INTERNATIONALFINANCIAL

MANAGEMENT

(Late) Dr. V.A. AvadhaniM.A., Ph.D. (U.S.A.), M.A., L.L.B., C.A.I.I.B.

* Retired Adviser in the Reserve Bank of India* Former Director of Research and Training in Bombay Stock Exchange* Former Adviser in Hyderabad Stock Exchange

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PREFACE

This book is intended for all students of Finance and Management, in all ManagementInstitutes and Universities. The objectives of the book are to provide students with aconceptual framework of financial decisions taken in a multinational company and tofamiliarise the students with the unique economic fundamentals and financial factorswhich challenge the financial manager in the international context. The book covers theentire syllabus, as approved by UGC on the subject of International FinancialManagement.

With increasing globalisation and opening up of the economies to free market forcesof competition and efficiency, the role of multinational trade and finance has grown byleaps and bounds in the last decade. This is particularly more relevant in the Indiancontext, where the rupee was made convertible on current account and export andimport trade is growing both in absolute and relative terms. The scrips of many corporatesin India are listed and traded in main foreign stock exchanges and Foreign FinancialInstitutions and Foreign Institutional Investors are operating in Indian financial marketsboth of equity and debt nature. Foreign capital flows and foreign investment are growingand gaining in importance. The international forces are throwing new challenges to theFinance Manager. It is in this context that the subject of International FinancialManagement has assumed vital importance to the students of Finance Management whowill be the future financial managers operating in international markets, for goods,services and finance. This book is intended to cater to their requirements.

This book is presented in simple non-mathematical terms, easily understandable tothe average students and lay executives of the corporates. This has the advantage ofharmonising the finance function with the investment function of the Financial Manageron the one hand and integrating the domestic finance with international finance, on theother. The material is kept as brief as possible, yet with a comprehensive coverage of allthe modules as approved by UGC and in accordance with their syllabus.

From time to time, it has been revised to incorporate changes in policy and empiricaldata. The author acknowledges all the faculty who have recommended changes and tothe Himalaya Publishing House Pvt. Ltd.

— Author

BRIEF CONTENTS

PART I BACKDROP OF INTERNATIONAL

FINANCIAL MANAGEMENT

1. Introduction to International Financial Management 3 - 11Introduction — Objective — Relevance to Management — FinanceFunction — Input Market — Output Market — Sources and Uses —Macro View of Foreign Flows — Sectoral Interdependence —International Flow of Funds — Conclusion.

2. International Financial Environment 12 - 22Political System — Good Economics is Good Politics — Social System—Information Technology — Financial Strength — Legal andEconomic System — General Environment — Examples — Factors inEnvironment — Role and Diversification — Role of FinancialInnovations — Forex Exposure — Role of Securitisation — Role ofBanks — Interest Rate Exposure — Multinational Corporations(MNCs) — Definition — Rationale of MNCs’ Domination.

3. Goals and Growth of Multinationals 23 - 31Emergence and Growth of MNCs — Special Features of MNCs —Traits of International Financial Manager — Growth of MNCs —Rationale of Growth of MNCs — The Hold of MNCs — EmpiricalEvidence — MNCs — Objectives.

4. International Business Methods 32 - 41Globalisation and MNCs — Global Winds of Change — NewChallenges and Opportunities — Importance of Global Factors —Cheaper Sources of Funds — Regulatory and Legal Framework —Adoption of Perfect Markets — Monopoly and Semi-MonopolyConditions — Global Sourcing — Global Organisational Restructuring— Components of Organisational Change — Divisions/Departments(Sub-Systems) — Structure and Systems — Pre-requisites forGlobalisation — Business Methods.

5. Nature of International Risk Exposure 42 - 54Introduction — Netting Method — General Risks — Nature of Risks— Measurement — Invoicing as a Risk Measure — Risks from GlobalForces — Risks from International Financial Architecture.

1 - 70

6. International Monetary System 55 - 70Objectives of IMF — IMF’s Role of Consultation — Sources of Funds— Quotas — Share Capital of IMF — Other Sources of Funds —IMF’s Lending Operations — Standby Arrangements — IMF Charges— Other Facilities — Exchange Rates and Par Values — InternationalMonetary Reforms — International Liquidity — Need for Reserves —Composition and Level — Adequacy of Reserves — Problems ofLiquidity — Augmentation of Liquidity — Special Drawing Rights(SDR) — SDR Allocation — Uses — SDRs of India — India’s IMFNet Position — Additional SDRs.

PART IIMANAGEMENT OF EXCHANGE AND

INTEREST RATE EXPOSURE

7. Determination of Exchange Rates 73 - 87What is Exchange Rate — Speculation — Exchange Rate Mechanism— Gustav’s Theory — Limitations — Spot and Forward Rates —Arbitrage — Indian Foreign Exchange Rates — Exchange Dealers —RBI and Exchange Market — Exchange Rate System in India —Floating Vs. Fixed Exchange Rates — Advantage of Basket ofCurrencies — RBI Policy Applied to Banks — Currency Deals —Trading by Banks — Exchange Rates Quotations — Cross CurrencyDeals — Cross Rates in Forex Market — Cross Currency Deals inIndia.

8. Forecasting Exchange Rates 88 - 99Introduction — Interest Parity — Traditional Model — ModernForecasting Models — Limitations — Risk in Export Markets —Hedging in Import Trade — Controls on Trade — Licensing Policy —Indian Shipping and Other Infrastructure — Problems of IndianShipping — Marine Insurance — Recent Exim Policy — CurrentAccount and Exchange Rate.

9. Balance of Payments (Equilibrium Vs. Disequilibrium) 100 - 117Definition — Accounting of Balance of Payments — Sources ofCompilation — Components of Balance of Payments — Balance ofPayments Data — Mechanism of Adjustment — Price Mechanism —Income Adjustment — Absorption Approach of Alexander — ElasticityApproach Vs. Absorption Approach — General Equilibrium Approaches— Measurement of Deficits — India’s Balance of Payments — SectoralBreakdown — Sources of Data — Role of Services in Balance of

71 - 165

Payments — Non-resident Inflows — Foreign Exchange Reserves —Foreign Assistance — Appendix — The Proforma of Balances ofPayments of RBI.

10. International Trade Flows 118 - 127Indian Trade Philosophy — Importance of Trade Transactions —Changes in Demand — Trade Gains — Generalised Trade Theory —Dynamics of Transactions in Trade — Effect of Tastes — TechnologyChanges — Trade and Growth in LDCs — Linkage — Forward andBackward — National Income and Trade (Exports) — Imports andGrowth — Terms of Trade — Conclusion.

11. Interest Rates Parity 128 - 149Role of Interest Income — Role of Interest Rates — Theories of InterestRate — Factors Influencing Interest Rates — Bank Rate and RefinanceRates — Nominal and Real Interest Rates — Nodal Factors InfluencingInterest Rates — Interest Rate Parity — Limitations of PPP Theory— Interest Rate Risk — RBI Guidelines on Risk Management inBanks — Role of Banks — Money Market Rates — Rates in Gilt-edged Market — Private and Government Bond Rates — Rates ofBorrowings and Lending by Banks — Interest Rates on Small Savings— Export Credit Interest — Level of Interest Rates — Structure ofInterest Rates — Reforms — Recent Deregulation Measures — TheYields of Different Types — Real Yield — Effects on Trade — Effectson Funds Flows — Effects on Exchange Market — Interest ParityInternational — Effects on Balance of Payments.

12. International Fisher Effect — Parity Relations 150 - 158Introduction — Basis of International Fisher Effect —PurchasingPower Parity (PPP) — Exchange Market Efficiency vs. Interest Parity— Fisher’s Equation and PPP Theory — Fisher Effect — InterestParity — Fisher Open Relation — Covered Interest Parity (CIP) —Uncovered Interest Parity (UIP) — Forward Margin and Parity Theory— Testing of Interest Parity — Inter-Relations Among Parities.

13. Time Factor in International Risks 159 - 165Introduction — Time Preference for Money — Applications — FutureValue of a Single Cash Flow — Sinking Fund Factor — Future Valueof an Annuity — Present Value of Annuity — Shorter CompoundingPeriod — Bond Valuation — Yield to Maturity — Equity Valuation— Management of Time Risk.

PART IIIMANAGEMENT OF RISKS IN

INTERNATIONAL TRANSACTIONS

14. Foreign Exchange Markets 169 - 182Functions — International Financial System and Forex Market —Foreign Sector and Forex Market — Bank’s Purchase and Sale —Instruments of Credit Traded — Foreign Exchange MarketComponents — Participants — Spot and Forward Rates — IndianForeign Exchange Market — RBI and Exchange Market — Mismatch— Need for Matching — Forex Management — Currency Derivatives— Swaps — Options — Futures — Sodhani Committee Report (1995)— Forward Rate Agreements (FRA) — Forward and Future Contracts— Currency and Interest Rate Swaps — Interest Rate Futures.

15. Government Influence on Exchange Rates 183 - 196Introduction — RBI as the Exchange Control Authority — AuthorisedDealers (ADs) — Money Changers — Permitted Method — OtherReceipts — Payment for Imports — Other Payments — Delegation toADs — Forward Covers —Securities — Foreign Currency Accounts— Non-resident Accounts — Non-resident (Bank) Accounts — Loansand Overdrafts — Blocked Accounts — Liberalisation of ExchangeControl — Capital Account Liberalisation — Recent LiberalisationMeasures — Sodhani Committee Recommendations — Exchange RateManagement — RBI on Exchange Control Norms.

16. Exchange Rate Risk Management 197 - 215Economic Exposure — Strength of Currency — Exchange Risk Defined— Factors Affecting Exchange Rates — Types of Risk in General —Exchange Rate Management in India — Full Convertibility of Rupee— Multilateral Investment Guarantee Agency — FERA Liberalisation— Trade and Exchange Risk — Exchange Rate and Currency Risk— Types of Exchange Rates — Arbitrage and Speculation — Risk inForeign Trade and Finance — Coverage of Risks — Market Makersin Foreign Exchange Market — Measurement of Risk — Risk inForward Market — Portfolio Management in Foreign Assets —Investment and Trading — Financial Engineering (DerivativeMarkets) — Financial Engineering — Recent Innovations Introduced— Interest Rate Risk Measures — Yield and Price Changes — Howto Cope with Interest Risk — Asset Liability Management (ALM) —Spread Management — Traditional Gap Management — RateAdjusted Gap.

167 - 278

17. Hedging in Derivative Markets (Futures and Options) 216 - 228Why Derivative Markets? — Pitfalls — Role of Regulator — Tradingin Derivatives — Problems — Currency Futures and Options —Futures and Forwards — Currency Options — Differences betweenFutures and Options — Market Structure — Futures Options — RiskManagement in India — Management of Financial Risks — Methodsof Meeting these Risks — Repos — Short Positions — Asset BasedSecuritisation — Strips — Credit Risk Management — Interest RateRisk Exposure — Interest Rate Swaps (IRS).

18. Hedging in Swap Market 229 - 242Motivation for Swaps — Economic Advantages of Swaps — CurrencySwaps — Debt-Equity Swaps — Nature of Swaps — Types of Swaps— Interest Rate Swaps — Fixed Rate Currency Swaps — CrossCurrency Interest Rate Swap — Multilegged Swaps — Basis Swaps— Interest Rate Swaps in India — Interest Rate and Currency Swaps— Advantages — RBI Scheme of Interest Rate Swaps — Spot andForward Rates — Speculation — Arbitrage— Hedging andSpeculation.

19. Operational Exposure — Risk Management 243 - 252What is Operational Exposure — Nominal and Real Exchange Rates— Nature of the Exposure — Effect of Quantity, Price and Factors— Firm’s Reaction — Transactions Effect — Politico-Economic Risksand Operational Exposure — Measurement and Management —Proper Invoicing — Need for Proper Planning — Hedging RiskExposure — Matching of Currencies — Impact of Taxation —Shortand Long-term Effects — Micro and Macro Effects — Conclusion.

20. Measurement of Politico Economic Risks 253 - 263(Country Risk Management)Introduction — Why Risk Rating? — Cost and Availability of ForeignFunds — Debt Burden of Countries — Credit Risk and Country Risk— Quantifiable Factors — External Debt and Debt Service Ratio —Balance of Payments Position — Foreign Exchange Reserves —Structural Imbalances — Proportion of External Trade to World Trade— Maturity Pattern of Debt — Liquid Reserves — Weightage toFactors — Investment Grade — Limitations of Grading — MIGGrading — Credit Rating of Debt Instruments — Credit RatingExercises — Standard and Poor — Nature of Country Risk — Methodsof Reducing Country Risk — Euro Money’s Country Risk Rating.

21. Management of International Transactions Exposure 264 - 278Introduction — Translation Methods — Managing AccountingExposure — Centralisation and Decentralisation — ManagingTranslation Exposure — Enterprise Risk Management — ExchangeRate Management — External Hedging — Currency Borrowingsand Deposits — Currency Futures — Currency Options — ExposureHedging — Forward Market Hedge — Managing Economic Exposures— Use of Real Effective Rates — Proactive Strategies — Componentsof Economic Exposure — Factors Influencing Sensitivity — IntegratedStrategy.

PART IVMANAGEMENT OF INTERNATIONAL BUSINESS

OPERATIONS AND PRACTICES

22. Operational Strategies of MNCs 281 - 292Introduction — Strategic Globalisation — Organisational Change —Role of FDI in Investment and Production — Technology Adaptation— Role of Cost Reduction and Quality Controls — Role of Brands andTrade Marks — Financial Strengthening — Mergers and Acquisitions— Consolidation — Global Joint Ventures Abroad.

23. Management of Multinational Operations 293 - 301Traditional Theory — Generalised Trade Theory — MultinationalCorporations (MNCs) — Definition — Rationale of the Dominance ofMNCs — Merits and Demerits — Re-assessment of the MNCs’ Role— Impact of MNCs’ Operations — Growth Theories.

24. Management of Global Business Practices 302 - 311Current Asset Management — Cash Budgeting — Multilateral Netting— Marketable Securities — Money Market Instruments (upto oneyear) — Investment Guidelines — Cash Planning and Budgeting —Cash Pooling — Inventory Management — Accounts Receivables —Inventory Optimisation.

25. Nature of International Business Finance — Practices 312 - 320Nature of Business Finance — Debt Crisis — Effects on Banks —Corporate Financing Decisions — Alternatives to Debt Financing —Capital Structure — Micro Level Debt Equity Ratio — Role ofExchange Market — Innovations — Types of Innovations — EmergingScenario.

279 - 359

26. Inter-Corporate Funds Flow 321 - 330Introduction — Transfer Pricing — Timing Flexibility — Use andMisuse of Inter Transfers — Functions of Management — Cost CurvesComparison — Strategic Cost Management — Ad Expenses of MNCs— Transfer Pricing Mechanism — Provisions of Income Tax Act.

27. Sources of Funds for MNCs 331 - 347General Sources — Domestic and Foreign Sources — M.N.C. andGlobal Finance — Capital Markets of Foreign Countries — EuroCurrency Markets — Money Market — Capital Market — CommercialBorrowing of India — Cost of Issue — Buyback of Shares —Limitations — Advantages — Modes of Buyback — Buyback inGlobal Aspect — U.S. Law — Indian Law — Inter-CorporateInvestments — Euro-Commercial Paper — Risks and Costs ofBorrowing — Financing Options — Objectives — Local CurrencyFinancing — Forms of Bank Credit — Commercial Paper — EuroNotes and Euro Commercial Paper — Costs of Alternative FinancingOptions.

28. Operations in International Financial Markets 348 - 359Financial Disintermediation — Globalisation of Markets —Securitisation vs Intermediation — Foreign Equity Market — ForeignBond Market — Foreign Bank Market — Euro — Euro CurrencyLoans Vs Euro Bonds — Note Issuance Facilities — FRNs — Debt VsEquity — Multinational Financial System — Transfer Pricing — Roleof Reinvoicing Centre — Leading and Lagging — Means ofTransferring Funds by MNC — Designing Global RemittanceStrategy.

PART VMANAGEMENT OF SHORT-TERM

INTERNATIONAL FINANCING

29. Short-term International Financing 363 - 371Short-term Market — Short-term Loans from Money Market —Forfaiting — International Leasing — Euro Market — SyndicatedLoans — International Banking — Capital Adequacy Standards —Corresponding Banking — Foreign Branches — Acquisitions — Growthof International Banking — Universal Banking.

30. Operations in International Money Market 372 - 381Introduction — Domestic Vs International Money Market — MoneyMarket Instruments — Example of Floating Rate Note — Bankers’

361 - 437

Acceptances — Letters of Credit — Stand by Letters of Credit —Euro-Currency Market — Why Euro-Currency Markets Thrive? —Ancillary Functions of Banks — Advantages — Loan Assignmentsand Participation — Note Issuance Facilities (NIFs) — OtherInstruments.

31. Operations in Foreign Currency Markets 382 - 396International Money and Capital Markets — Exchange Markets vs.Currency Markets — Origins of the Currency Markets — Dealers inthe Market — Euro-Bond Markets — Magnitude of Trade — MarketFeatures — Instruments Issued and Traded — Lawyers and Auditors— Euro Bond Clearing and Settlement System — Asian CurrencyMarket — Petro-Dollar Market — Impact on Exchange Markets —Segments of the Market — Sources and Uses — Growth of the Marketin Euro-dollars — Techniques of Operations — Importance of theMarket — India and Foreign Currency Markets — InternationalFinancial Centre in India.

32. Management of Corporate Financing 397 - 410Wide Range of Sources — Minimisation of After Tax Capital Costs —Factors Influencing Global Financing — Objectives of Strategy —Reduction of Operating Risks — Management of Political Risks —Managing Product Risk — Warding Off Raids — World Wide FinancialStructure — Foreign Subsidiary Capital Structure — ParentCompany’s Guarantee — Joint Ventures Vs Subsidiary —International Leasing — Double-dip Lease — Leasing and TaxPlanning — Debt Equity Norm in Global Finance — FactorsInfluencing the Costs of Capital — Weighted Average Cost of Capital— MNC’s Cost of Capital — CAPM (Capital Asset Pricing Model) —Dividend Equalisation Model — Use of Beta — Risks of MNCs —Empirical Evidence.

33. Conceptual Backdrop of Working Capital 411 - 429Introduction — Management of Cash — Non-Current Cash —Marketable Securities — Valuation — Receivables and Payables —Trend Analysis — Comparison Through Index Numbers — TrendRatios — Working Capital Management — Cash Flow Statements —Liquid Assets — Current Account — Lock Box System — Cash andLiquid Assets — Models for Determining Optimal Cash — BaumolModel — Miller and Orr Model — Probability Approach — StochasticModels — Probability Merits — Inventory Model of EOQ for Cash.

34. Working Capital Management 430 - 437Receivables — Credit Standards — Cost Benefit Analysis — CollectionCharges — Credit Standing of Customers — Impact of Credit Decision

— Inventory Management — Economic Order Quantity — OrderPoint and Safety Stock — Special Features of MNCs — Financing ofWorking Capital.

PART VIMANAGEMENT OF LONG-TERM

INTERNATIONAL FINANCING

35. Project Appraisal and Capital Budgeting 441 - 453Pay-back Period — ARR or Average Rate of Return Method —Discounted Cash Flow Method (D.C.F.) — Rules of Selection of aProject — Internal Rate of Return (IRR) — NPV and Relative NPV— Capital Budgeting by MNCs — NPV Formula — Incremental CashFlows — Adjustment for Taxes and Other Hurdles — MNC’s Outlook— Exchange Rate Changes and Inflation — Growth Options — Useof D.C.F. — Free Cash Flow Method (FCFM) — Corporate Treasuryas a Profit Centre.

36. International Capital Flows 454 - 476Introduction — Theory of Foreign Capital Flow — Aid Requirements— Criteria Governing Aid — Types of Aid — Forms of Aid — DesirablePattern of Flows — Advantages and Disadvantages of Aid — DebtBurden of Government — Foreign Investment in India — LatestForeign Investment Policy — NRI Schemes FCNR SchemeAmendments — Foreign Currency (Non-resident) Accounts (Banks)Scheme — International Investment Position — Indian Aid to OtherCountries — Joint Ventures — Government Policy Guidelines —Nature of International Flows of Capital — Banking Sector —Government Sector — Corporate Sector — World Trends — AgenciesInvolved — Capital Flows and Growth — MNCs’ Role in ForeignInvestment — Multinational Financing Agencies of World Bank —The International Development Agency (IDA) — InternationalFinance Corporation (IFC) — The Bank for International Settlements(BIS) — Asian Development Bank (ADB) — Other RegionalDevelopment Banks.

37. Foreign Investment (Direct and Portfolio, GDR and ADRs) 477 - 493Introduction — Globalisation of Indian Markets — External Debt ofIndia — Foreign Investment into India — Commercial Borrowing —Global Instruments — Other Equity Linked Instruments — NewGlobal Instruments — GDR Features — Pre-issue Operations —Domestic Statutory Clearances — Central Role of Lead Manager —Borrowing Through Euro-Issues — Government Guidelines — Issuesin Foreign Markets — Banks and Indian Companies — Banks and

439 - 544

Foreign Capital — Exchange Rate and Banks — Policy on ExternalCommercial Borrowings (ECB) — Changes in ECB Guidelines — TheRule Book — NRI Investments — Foreign Financial Institutions —Foreign Institutional Investors — Portfolio Management — NRIsInvestments.

38. Financing of Debt and Equity Investments 494 - 501(Through Global Markets)World Trends — Trends in India — Micro Picture — Costs of Capital— Management Policy — Merits and Demerits of Equity — Meritsand Demerits of Debt — Empirical Position — Determinants of FDI— Determinants of Portfolio Investment.

39. Measurement of Portfolio Risk 502 - 507Introduction — Systematic and Unsystematic Risks — Other Risks —Risks Measurement — Range of Variation — Why Credit Rating? —How to Minimise the Risks? — Measurement of Risk — Beta — RiskReturn Analysis — What is Portfolio Risk — Management of Portfolio.

40. Risk Measurement in Investments 508 - 521CAPM — CPM Line — Security Market Line (SML) — CAPM Analysis—Market Model — Uses and Limitations — Duration (Example) —CAPM Example — Diversification — Why Diversification — Exampleon Measurement of Risk — Calculation of Standard Deviation —Simple Diversification — Markowitz Diversification.

41. Portfolio Diversification and Risk Reduction 522 - 532What is Diversification? — Random Diversification — InternationalDiversification — Why International Diversification? — Risks inForeign Investments — FFI’s Investment in India — NRI Investmentin India — Passive International Investment Strategy — ActiveInternational Investment Strategy — Return Forecasts — Evans-Archer Study and Diversification — Naive Diversification — Evansand Archer’s Study.

42. Multinational Taxation 533 - 541Need for Tax Planning — Bilateral Tax Treaties — Allocation ofIncome — Transfer Pricing for Tax Planning — Use of Inter-CompanyLoans — Tax Incentives — Organisational Set up of MNC — TaxReliefs and Rebates in India — Tax Credits — Tax Havens —Investment Decisions on Tax Planning — Corporate Goals —Investment Incentives — Global Trends — Tax Rates on Corporates— Grey Areas in International Tax Planning — Transfer PricingMethods — Measures to Plug Tax Loopholes.Bibliography 543 - 544

CONTENTS

PART I BACKDROP OF INTERNATIONAL

FINANCIAL MANAGEMENT

1. Introduction to International Financial Management 3 - 112. International Financial Environment 12 - 223. Goals and Growth of Multinationals 23 - 314. International Business Methods 32 - 415. Nature of International Risk Exposure 42 - 546. International Monetary System 55 - 70

PART IIMANAGEMENT OF EXCHANGE AND

INTEREST RATE EXPOSURE

7. Determination of Exchange Rates 73 - 878. Forecasting Exchange Rates 88 - 99

9. Balance of Payments (Equilibrium Vs. Disequilibrium) 100 - 11710. International Trade Flows 118 - 12711. Interest Rates Parity 128 - 14912. International Fisher Effect — Parity Relations 150 - 15813. Time Factor in International Risks 159 - 165

PART IIIMANAGEMENT OF RISKS IN

INTERNATIONAL TRANSACTIONS

14. Foreign Exchange Markets 169 - 18215. Government Influence on Exchange Rates 183 - 19616. Exchange Rate Risk Management 197 - 21517. Hedging in Derivative Markets (Futures and Options) 216 - 22818. Hedging in Swap Market 229 - 24219. Operational Exposure — Risk Management 243 - 25220. Measurement of Politico Economic Risks 253 - 263

(Country Risk Management)21. Management of International Transactions Exposure 264 - 278

PART IVMANAGEMENT OF INTERNATIONAL BUSINESS

OPERATIONS AND PRACTICES

22. Operational Strategies of MNCs 281 - 29223. Management of Multinational Operations 293 - 30124. Management of Global Business Practices 302 - 31125. Nature of International Business Finance — Practices 312 - 32026. Inter-Corporate Funds Flow 321 - 33027. Sources of Funds for MNCs 331 - 34728. Operations in International Financial Markets 348 - 359

PART VMANAGEMENT OF SHORT-TERM

INTERNATIONAL FINANCING

29. Short-term International Financing 363 - 37130. Operations in International Money Market 372 - 38131. Operations in Foreign Currency Markets 382 - 39632. Management of Corporate Financing 397 - 4133. Conceptual Backdrop of Working Capital 411 - 42934. Working Capital Management 430 - 437

PART VIMANAGEMENT OF LONG-TERM

INTERNATIONAL FINANCING

35. Project Appraisal and Capital Budgeting 441 - 45336. International Capital Flows 454 - 47637. Foreign Investment (Direct and Portfolio, GDR and ADRs) 477 - 49338. Financing of Debt and Equity Investments 494 - 501

(Through Global Markets)39. Measurement of Portfolio Risk 502 - 50740. Risk Measurement in Investments 508 - 52141. Portfolio Diversification and Risk Reduction 522 - 53242. Multinational Taxation 533 - 541

Bibliography 543 - 544

PART IBACKDROP OF INTERNATIONAL

FINANCIAL MANAGEMENT

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IntroductionInternational Financial Management has assumed an important role in the Indian

economy, with FDIs, FFIs and FIIs playing a key role in the stock and capital markets.The recent estimate is that FIIs hold about 18% of market capitalisation of the listedcompanies, in the Stock Exchanges in India. Many Indian corporates are listed andtraded on Foreign Stock Exchanges. Many foreign banks were permitted to operate inIndia and Indian banks have become more globalised in their operations. Indian exportsare growing at a rate of 12%, per annum as envisaged in the Tenth Plan. Nearly morethan 50% of the manufacturing output in India is exported on an average. The total ofexports and imports trade crossed U.S. $ 455 billion and its foreign exchange assets arealso more than U.S. $ 300 billion. With such growing importance of global sector, theoperations in International Finance are also growing faster than ever before.

World trade was estimated to grow in 2008 at a rate of 4% and that of the developingcountries at 8% to 10%. The scope of expansion for International Financial Managementhas increased. India has a major role to play in the world trade and finance. Net capitalflows into Emerging Market economies on non-official basis were estimated atU.S. $ 320 billion in 2014.

India has emerged as a Creditor Country among the IMF of members. World Bankis reported to be planning to issue rupee bonds in India to raise rupee resources. Indianrupee has shown strength and resilience that it was in demand in International Finance

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1

INTRODUCTION TOINTERNATIONAL

FINANCIALMANAGEMENT

International Financial Management4

Markets. Many big companies in India have become international market participantsand are rated as domestic MNCs in addition to many MNCs of foreign origin in India:The above picture provides a brief overview of the importance of International FinancialManagement. Gross capital inflows into India Through FDI are NRIs continued to groweven in a Recession year of 2009.

ObjectiveThe object of this chapter is to develop linkages between the domestic economic and

financial system and international financial system and to provide theoretical andanalytical inputs necessary for a student of international financial management. Thecorporate executives have before them, the corporate goals for implementing themanagement function, finance function or marketing function. All these functions areinterrelated and connected with the international financial system. The finance manageror the production manager operates at the corporate level in both domestic and foreignmarkets corresponding to the domestic and foreign sectors. If we start with the productionfunction of a corporate entity and analyse the finance function of the manager, hisoperations in the foreign sector provide the link between the corporate sector, on the onehand, and the foreign sector, on the other. The mutual interactions between foreignsectors of various countries lead to the emergence of the international financial system.The foreign sectors are the cementing blocks of the international financial system andinstitutions operating in the international financial system are closely connected with theforeign sectors of the various economies. In this chapter an attempt has been made totrace back the operations in the international finance system from the international levelto the national level through various financial institutions and banks and at the nationallevel, from these institutions to the corporate units and the company managers. In viewof global importance to operations of international trade and funds flow internationalfinancial management has assumed a vital role.

There are various facets of the international financial system (IFS) which areanalysed in depth in the chapter. To start with, an important aspect of internationalfinancial system is international trade which accounts for the largest chunk of internationalcommercial and financial relations and payments. Thus, a part of the treatment of thisbook is on the subject of international trade and finance, Balance of Payments andrelated aspects of international economic relations. Another aspect is the institutions andorganisations in it under which banks, national and international financial institutionshave all found a place in this book.

The sub-markets in the financial system such as in foreign currency, correspondingto short-term flow of funds as between countries investments in foreign money marketsand in foreign claims, etc., are reflected in financial flows as between countries throughthe flows of money payments and receipts. Thus, both international trade andinternational currency and exchange markets are closely connected and are dealt with.Yet another aspect of the international financial system is the role of term lending andforeign aid in the flows of trade between countries, corresponding to long-term flows asbetween countries. It is in this context that foreign trade and aid are discussed asimportant components of the international financial system as short-term and long-termwings of the operations of the International Financial Manager.

Introduction to International Financial Management 5

Introduction to International Financial M

anagement

Relevance to ManagementAs this book is intended for students and corporate executives, we should set out in

the beginning itself the relevance of international finance to their day-to-day work.Domestic finance and international finance are next-door neighbours-both complementaryand competitive- viewed either as sources or uses of funds.

Firstly, in a fast-growing world economy and world markets, it would be naïve fora corporate executive to confine himself to the domestic markets and domestic financealone. The days of national autarky have gone by and we are in a world ofinterdependence. With a fast growing network of transport and communications, theworld is getting closer and a finance manager can hardly ignore the forces operating onhim from the international plane as much as from the domestic plane.

Secondly, as the operations and systems in domestic and international finance aredifferent, the factors influencing them need to be studied separately.

Thirdly, in a world of competition and survival of the fittest, the managerial functioninvolves choosing the right input mix both from home and abroad and the right outputmix suitable for home and foreign markets and expose oneself to the winds of competitionboth at national and international levels. These aspects are clearly noticed in India, withthe opening up of the economy since July 1991 through Economic and Financial Reforms.

It is to be conceded that the impact of the foreign sector on the activities of thecorporate executive is more keenly felt in some lines than in others. Such lines are inexportable goods and services, finance, shipping, airways, tourism etc. If the corporateentity belongs to the sector of multinational companies, foreign-owned companies,subsidiaries or branches of foreign companies etc., international forces are relativelymore important. At any rate, any management executive can ill-afford to be blind to theinternational economic and financial scene even if he is not directly involved in it asthese forces operate on him in the modern world.

Finance FunctionThe objective of the finance function of a manager may be set out in different ways.

He may aim at optimising the value of his assets or minimising the worth of his liabilities.Put in differently, he may maximise his gross profits or net profits and minimise risksor aim at optimising the market value of his companys shares. Looked at from anyangle, the management basically aims at economy, efficiency and productivity leading togreater profitability. For this purpose, he concentrates on the efficient management ofcash and credit so far as the financial aspect is concerned. But more importantly, he hasto consider the production function of which cash and credit are inputs. The financefunction is also closely related to marketing function also, as the latter involves the useof cash and credit. The manager has to take into account the international forces in thepreparation of plans and budgets for resource inflows and outflows and in input andoutput markets. In the raising of funds and use of such funds, the cost of alternativeuses and sources have to be considered both at home and abroad. Finance Function isall pervading being related to all activities of the firm, and particularly to the Management.

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In terms of the real sector or the financial sector, the manager has to observe thecriteria of efficiency and productivity etc., in the input market and output market andin allocation of physical resources or financial resources. In the input and output marketsas well as in financial markets, both domestic and foreign, forces have to be reckonedwith.

Input MarketIn the input market, physical and financial inputs are fed into the productive

system. Physical inputs relate to physical capital equipment, plant and machinery, rawmaterials, spare parts and intermediate (semi-finished) products, etc. They may comefrom domestic or foreign markets. Financial inputs relate to moneys spent on wages forlabour or cash kept for current liabilities or contingencies. Such inputs can be securedboth from domestic markets and foreign markets. As such, a cost calculus has to be madefor the right mix of inputs and the right sources of supply of such inputs so as tominimise the costs for a given product mix. It is possible that some raw materials orspares are more cheaply available abroad than at home and due to free access to suchmarkets the manager may plan for a mix of inputs at the least cost, subject to thetechnical feasibilities in the production function. The markets, both domestic and foreign,have to be assessed for these inputs in terms of costs and prices and alternative sourcesof supply explored. This is an area in international economics and finance. In the supplyof financial inputs for production purposes one has to take into account the need for cashand credit and the relative proportions of each both from home and abroad and to assesstheir relative costs. Marginal costing of cash and credit is part of the wider subject of cashmanagement. The cash component as an input in the production function is part of thesubject of production management, while the overall management of all funds is in thedomain of financial management.

In a subsidiary or branch of a foreign company, foreign sources play a more importantrole even in financial inputs. In more recent years, outsourcing in the I.T. and relatedareas has become important due to its cost reduction advantages. Such exercises relatingto financial inputs have to be made after an assessment of cash inflows and outflows,both on current and capital accounts. On the capital account, sources and uses of fundsfor investment also become an important pre-requisite for planning for credit. These willbe discussed below under sources and uses of funds.

Output MarketIn the output market, the sale of final and intermediate products can be made both

in domestic and foreign markets and mix of them. International marketing andinternational finance are closely interlinked and flows of finance follow the flows oftrade. Marketing is an important pre-requisite for trade. International trade andinternational finance are close complements. The costs of production and selling costs andthe available margins both on domestic sales and foreign sales have to be considered.Here again, it is assumed that there is a free market in India and abroad or trading ispossible subject to satisfying all the requirements of the government policy in this regard.A cost calculus has to be made for planning for the right mix of sales at home and

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abroad. For an assessment of the demand prospects abroad, we need to know thealternative sources of supply in such markets, demand and supply elasticities, costs andprices of such alternative sources, transport and selling costs etc., which are the subjectof international economics and finance. In India due to the premium put on export salesby government policy, the cost calculus has to take into account this aspect also.

Sources and UsesAt the micro level of a company, an analysis of the sources of funds reveals that

broadly there are three categories of sources:(i) Savings of the company which are its retained earnings,

(ii) External sources (domestic) from the capital and money markets such as banks,all-India or State-level financial institutions, government or the public and

(iii) Foreign sources, namely, markets, institutions and persons abroad. The lastcategory can in turn be specified as follows:(a) Credit from private parties, viz., trade credit, buyers credit, etc.;(b) Foreign government credit, viz., government to government line of credit,

foreign aid or grants or loans;(c) Resources from international or inter-regional bodies such as IFC, IBRD,

foreign banks or Euro-currency markets etc.; and(d) Non-resident individuals and institutions.

The same analysis holds good at the sectoral and national level. In fact, theemergence of international financial markets can be traced to this sectoral interdependence,including the foreign sector and intranational dependence. Basically, as no country isself-sufficient or autarkic but is dependent on other countries for something or the other,international economic and commercial relations emerge. These are referred to later inthis chapter.

In a similar fashion, it would be appropriate to set out the pattern of use of fundsof any company into various sectors of the economy, including the foreign sector.Dispensation of funds for current or capital expenditures in domestic markets andinternational markets can be separately set out. Such an analysis is particularly morerelevant to multinational corporations and branches or subsidiaries of foreign companiesin whose case foreign markets and foreign sources of supply play an important part. Thehead office or the holding company may spend a part of its funds in investment in thehost country, make inward remittances for working capital or investment purposes andoutward remittances for royalty and dividend, payments or technical fees.

Macro View of Foreign FlowsRBI Company Finance Studies throw light on the macro-view of Foreign inflows

and outflows in the Corporate Sector. These are published in RBI Bulletins regularly.A large number of smaller companies contribute larger foreign exchange earnings to thecountry. It is true that both expenditure and earnings on foreign account are concentrated

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in a small number of large foreign controlled Indian companies and multinationalcorporations, but they may not add much to the not accrual of foreign exchange. A largenumber of small companies do not operate on such a large scale, but add substantiallyto our net accrual of foreign exchange. In more recent years, the accrual of reserve isdue to inflows on current account for services remittances and due to depreciation ofdollar, and capital inflows for FDI, and NRE deposits.

Sectoral InterdependenceInternational financial markets emerged out of the felt need to facilitate operations

of nations arising out of the commercial and financial transactions with the rest of theworld. This emergence can be attributed logically to: (a) Sectoral interdependence, and(b) National interdependence.

It would be apt to set out here the inter-relations between the micro-level operationsof a finance manager with the macro-level working of the corporate sector and foreignsector. A finance manager is a micro unit in the corporate sector. The environment hefaces is competition from other similar units in the corporate sector and as suppliers ofinputs or as consumers of output. Besides, the corporate sector, in turn, is interlinkedwith all other sectors of the economy. The micro-level manager is thus faced with a totalenvironment of the economy which includes foreign sector, and it is thus relevant to himto be familiar with the international financial system, which is the product of developmentsin the foreign sectors of all the world economies.

The corporate sector is a part of the total business sector having trading andmanufacturing activities. The corporate sector is also connected with all sectors of theeconomy, namely, government sector, household sector and foreign sector either assuppliers of inputs or as consumers of output. Besides, all these domestic and foreignsectors are interconnected through the flow of funds and savings from one sector to theother. In each sector, there are both savers and investors. Only the household sector isa net saver in India. The household sector is also a supplier of factors of production suchas labour, management, enterprise etc. For some time in the past, foreign sector was anet saver, as there was a net balance on current account of our balance of paymentsleading to the accretion to our foreign exchange reserves. We are running huge deficitsin merchandise trade account for a long time which was offset by positive balance on thenet invisible trade account. For some recent years, we are having a negative savings inthe foreign sector leading to a loss of our foreign exchange reserves. If there is a netinflow of funds from abroad either as foreign credits, grants, etc., or borrowings fromforeign governments, international bodies etc., there may be a positive balance, in thebalance of payments and foreign savings would accrue. The surplus savings in somesectors would flow into other sectors with deficit. In the corporate sector where investmentis invariably more than their available savings, the units have to depend on other sectorsto finance them. These savings may flow directly from the government sector or householdsector or indirectly through financial institutions, banks and other agencies. It wouldthus, be clear that the corporate sector is intricately connected with all other sectors ofthe economy either as suppliers of inputs of production or suppliers of factors of production,including land, labour, capital or enterprise or consumers of their products or services.

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They are also connected with other sectors of the economy through inflow or outflow offunds or savings or financial assets-moneys or near money assets or financial flows.

Another aspect of interdependence of the various sectors of the economy is foreignprivate investment in the domestic economy or Indian investment abroad. The investmentmay take the form of

(i) Equity participation in Indian enterprises,(ii) Investment in bonds or debentures,

(iii) Granting of loans or credits either on government to government basis or partyto party basis in the private sector,

(iv) Joint ventures in third countries and(v) Technical consultancy or know-how participation etc. Transfer of technology is

also one of the aspects of the international commercial and financial relationswhich is necessary for a sustained rate of growth at the lowest possible cost andthe highest level of productivity.

All the inputs of the corporate sector come either from the household sector aslabour, capital or enterprise or from Government sector as infrastructure, land, electricity,water etc., or from agriculture or industry (business sector) as raw materials, intermediateproducts, spares parts etc.

Particularly more relevant for our discussion is the contribution of foreign sectortowards inputs of the corporate sector in the form of physical capital, plant, machinery,spares, raw materials, etc., or financial inputs in the form of short-term credits orinvestment in financial assets, etc. The inflows into India are through FIIs for portfolioinvestment and through MNCs for direct investment in equity or debt forms.

Such interdependence between the corporate sector and other sectors is also noticedin the field of outputs. The main consumers of some products may in fact be the foreigners.Either in respect of consumer goods or capital goods, there is a good element of foreigndemand, particularly from the less developed countries. In view of the vastness of ourdomestic markets, the executives of the corporate sector rarely explore the foreign markets,unless the products are export-oriented. With the projected expansion of the industryand limitations in the domestic markets, the present executives may have to think morein terms of foreign markets than of domestic markets. More recently, export-orientedindustries and 100 per cent export units are being encouraged by the government in thelight of the prevailing balance of payments difficulties of the country and increasingexport shortfalls. Besides, the philosophy of the government is also veering round to theview of making our economy more competitive with a greater role allocated to the privatesector. The recent trend to globalisation and opening up of the economy to free marketforces make the foreign sector more relevant than before. The cost consciousness andcompetitiveness has increased in the Indian enterprise. In such an environment, the roleof foreign sector can be hardly overemphasised when the chilly winds of competition andcost consciousness make the present executives of the corporate enterprise more alert andinformed on both the domestic and external sectors. The foreign environment would beequally important and more challenging than the domestic market due to the ever

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changing scene of demand and supply forces, competition and cost price factors operatingfrom all sides of the world. These may hopefully improve the efficiency of factors andlower the costs of production.

There is another reason why the foreign sector is more important to India, namely,the limits are already reached in the domestic markets and the scope for further expansionof markets lies abroad. Besides, there is the debt service burden which we carry due toour reliance on foreign credits during the last few decades of our planning. This burdencan be discharged by a continuous flow of goods and services outside the country leadingto an export surplus for the nation.

In the output market, the domestic household sector has been the main consumerin India, followed by the government sector which needs the output of the corporatesector both for capital formation and current consumption. Besides, the government withits contracting role in the economy has got less say in the affairs of the corporate sectortoday and is likely to become lesser in future due to their avowed policy of a greater rolefor the private sector in the years to come. The business sector comprising industry andagriculture continue to consume the products of the corporate sector as intermediates orraw materials for manufacture or further processing. These facts are brought out in anyanalysis of input-output matrix tables for the economy, brought out by the ISI and CSO.

International Flow of FundsWe have seen that national economy of a country is composed of a number of

sectors, including the foreign sector and the interdependence of these sectors either assuppliers of savings or of factors of production, or of other inputs in the productiveprocess or as consumers of their output leads to economic, commercial and financialtransactions as between these sectors. It is such transactions between the domestic sectorsand foreign sector that gives rise to the international financial system.

An extension of this principle of mutual interdependence to the case of nationaleconomy of one country depending upon that of others lends further support to ourthesis that emergence of international financial markets is the result of suchinterdependence and intra flow of funds. Thus, no modern nation/state is self-sufficientnor is it closed to external forces from other nations and states. This dependence is theresult of the expanding civilisation and modern socio-economic systems. It is now wellrecognised that countries are interdependent in various degrees resulting in economiccommercial and financial transactions among them. Such interdependence is a necessarybut not a sufficient condition for the emergence of international financial markets. Butthe conquering of the distance and time by revolution in telecommunications, electronicmedia and information technology has brought the world together and led to a sufficientcondition for emergence of International Financial Management, as an area of vitalimportance. More importance is given recently to globalisation and privatisation leadingto greater international interdependence.

The interdependence of nations can be ascribed to the following factors:(1) Differential factor endowments and natural endowments in different countries,

leading to different production functions.

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(2) Different stages of growth of industry, agriculture and other sectors in theeconomies of these countries, and different levels of savings and investment.

(3) Differentials in technological advancement, R&D, and economies of scale.(4) Differences in habits, tastes and consumer preferences, leading to different

demand functions.(5) Differences in standards of living and incomes, leading to flow of funds through

grants, loans etc.

ConclusionIt would thus, be seen that the importance of international financial management

can be traced to the sectoral and national interdependence which leads to internationaleconomic, commercial and financial relations as between countries. International trade,aid and financial flows account for the bulk of such transactions as between nations. Thebasic economic principles of efficiency, productivity and least cost optimisation processnecessitate the use of inputs both domestic and foreign and flow of goods and servicesacross national borders, provided there are no barriers to such flows. The result is theexchange of goods and services involving payments and receipts as between countriesand exchange of one currency for another and borrowing and lending of money or nearmoney assets across borders. These transactions and trading in foreign currencies, foreignassets or liabilities and foreign claims constitute the international financial system, andare the subject matter of International Financial Management.

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